Ukraine Reform Monitor: March 2018

Summary: Reforms in Ukraine have taken a back seat during a protracted season of electoral politics. A key question is whether the rival factions can compete peacefully and avoid destabilizing the country again.

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This is the eighth Ukraine Reform Monitor published by the Carnegie Endowment for International Peace. Ukraine has little more than a year to go before the presidential contest, expected in March 2019, and a parliamentary vote due to be held later the same year. Reforms have taken a back seat to electoral politics. In this and forthcoming publications on Ukraine, Carnegie’s team of analysts will focus on key political and economic factors likely to shape the upcoming contests and determine their outcomes on regional issues.

The monitor is part of Carnegie’s Reforming Ukraine project and is supported in part by grants from the Center for East European and International Studies (Zentrum für Osteuropa- und internationale Studien, ZOiS) and the Open Society Foundations.

Ukraine’s Reforms Await the Voters’ Verdict

In the four years since the 2014 Revolution of Dignity in Ukraine, progress on reforms has been mixed. The reform process is now likely to be disrupted by the protracted political season preceding the 2019 presidential and parliamentary elections in which Ukraine’s voters will get their first chance to pass verdict on the domestic changes that have shaken their country since 2014.

Over the past four years, on President Petro Poroshenko’s watch, Ukraine has achieved macroeconomic stabilization and reformed or established several important institutions, such as the police, the Supreme Court, and new anticorruption agencies. Yet major structural problems remain. The country still suffers from the effects of oligarchic monopolies, an overregulated economy, a challenging business environment, and weak rule of law.

Large numbers of ordinary Ukrainians are less than enthusiastic about what the politicians have done since 2014, believing they have made major sacrifices, while the elites have been insulated from the economic downturn and carry on with business as usual. After a catastrophic crash, economic recovery has been steady but slow. Even though consumption has returned to pre-crisis levels, many feel angry. Frustration is connected to the growth of prices and the behavior of authorities. There are disturbing estimates of mass emigration from the country, suggesting that hundreds of thousands of Ukrainians are voting with their feet.

The country also faces a dramatic challenge between the demands of state and nation building. Those Ukrainians who believe that the former should be prioritized have embraced the fight against corruption as their key focus. Those who believe that the latter is the most important task insist above all on strengthening Ukrainian national identity and reducing Russia’s influence. The two camps coexist uneasily, but while the wave of patriotism that swept the country after Russia’s aggression has made Ukraine more resilient, it has also resulted in challenges to free speech and state-sanctioned violence.

Poroshenko’s challenge is to find a message to re-enthuse disillusioned voters, when his record in office evokes disappointment. His administration has pushed through important structural reforms, of education, healthcare, and public administration, and has begun a comprehensive decentralization program that delivers localized public services across the country. The latter has brought clear political dividends, in the form of serious hikes in support for local governments and mayors.

Even though poverty has fallen, Poroshenko’s popularity has plunged—in part because he has been unwilling to put his business interests aside and has thus created at least the impression of a major conflict of interests in the nation’s highest office. The president is also criticized for his tendency to micromanage and for placing loyalists throughout the government even at the expense of competence, as well as for undermining those institutions that are intended to check and balance his authority.

The reform process is likely to continue despite Ukraine’s somewhat tarnished image in the West, and at its own pace. Decentralization and reform of public administration and the energy sector will probably advance, and a new law will pave the way for a smoother privatization process.

But as the 2019 elections approach, domestic political fights will inevitably overshadow all these measures. A key question for the next twelve months is whether the rival factions within the political elite can compete peacefully with one other and avoid destabilizing the country again. Against this background, Ukraine’s Western partners will ponder how far they can push the government to continue the reforms that they believe are essential for the country’s long-term prosperity and that will sustain their support.

Poroshenko Loses Support

Ukraine’s reform agenda is also held hostage by Poroshenko’s desire to be reelected for a second term. His priorities are at odds with those of Ukraine’s principal Western partners—the IMF and the EU. Poroshenko’s agenda is to secure Western assistance for the Ukrainian military, mobilize patriotic constituencies, and deliver more socioeconomic benefits to the public. The West insists on Poroshenko’s government establishing an independent anticorruption court, raising the gas price (again), and maintaining austerity in its fiscal policy.

In a context of low public support, high political uncertainty, and widely available small arms, the authorities are nervous about even small protests. This may explain the aggressive suppression of the antigovernment campaign headed by former Georgian president Mikheil Saakashvili. On February 12, Saakashvili was detained and deported to Poland in a process that was almost certainly illegal. The tent camp he had set up—in imitation of the Euromaidan—was later forcibly shut down.

Poroshenko needs to recover a large measure of public support and trust if he is to be reelected. Former prime minister and social populist Yulia Tymoshenko was the presidential administration’s preferred option to be the main opposition challenge, given her checkered past. The number of undecided voters—up to 40 percent of the population—potentially leaves the door open for new faces, rebranding, wild cards, and unexpected alliances. As the entry costs to Ukrainian politics remain high, a new party or candidate is unlikely to be successful at the polls without financial support from oligarchic patrons.

However, Poroshenko and his remaining allies may be looking for other options, as the latest polls show the opposition well ahead of the ruling parties. As Tymoshenko is now leading with 25 percent, while Poroshenko trails behind with only 9.8 percent support, the leadership may consider constitutional changes that would reduce presidential powers and again give Ukraine a parliamentary system. If this public opinion trend continues, the long-negotiated common election approach of the ruling coalition—the Poroshenko Bloc and the Popular Front—won’t be feasible, and even the Poroshenko Bloc may start to erode.

Anticorruption, the Key Battle

Since 2014, Ukraine has launched and enacted more reforms than during the preceding twenty-five years. The government has established brand new institutions such as the patrol police and reformed old ones like the Supreme Court. The military has undergone a substantial overhaul, public procurement is more transparent, decentralization and public administration reforms have empowered new actors. The business environment has improved, albeit starting from a very low base. The country has its first-ever energy efficiency program, and reform programs are under way in the healthcare and education systems. The reforms have helped deliver a visa-free regime with the EU, which means that Ukraine now has the highest degree of travel freedom of the former Soviet republics, excluding the EU member Baltic states.

There is still a long way to go. Many of the reforms look good on paper while implementation, budgetary support, and informational campaigns are lacking. Moreover, there is much foot-dragging and pushback in areas where elite interests are at stake—mainly in the area of anticorruption and judiciary reforms. In fairness, public expectations may have been too high. The post-Euromaidan reform process has drawn attention to problems that had lain untouched for twenty-five years. For example, while there have been real efforts to tackle corruption, public perceptions of the extent of corruption have risen since 2014, thanks to greater media scrutiny of the issue.

Corruption—some call it simply “state capture”—overrides all other issues. Under intense Western pressure, the Poroshenko government has made progress in reducing petty corruption and increasing transparency. It has created Pro-Zorro, the online procurement system and a new system of electronic asset declarations by government officials. It has also established new anticorruption agencies such as the National Anticorruption Bureau (NABU) and the Specialized Anticorruption Prosecutor’s Office.

But progress to advance the anticorruption agenda further has been uneven, at best. NABU has opened hundreds of criminal cases, including against the head of the State Fiscal Service, Roman Nasirov. However, very few cases have resulted in jail sentences thus far. Parliamentarians and government officials have declared their assets but evaded questioning on how they were acquired, with Poroshenko himself resisting calls to repatriate his offshore assets. Most notably, the government has required civic activists to report on their income on a par with civil servants. While not prohibited by law, this appears to be an act of revenge against the government’s civil society critics.

At the same time, progress on judicial reform, dubbed by Poroshenko as “the mother of all reforms,” has been painful. One reason for this is that, as Vox Ukraine noted, the government decided to first adopt the legal framework for strengthening the judiciary’s independence, and only then moving to replace judges. This was unpopular with the public because some judges with tarnished reputations have been retained.

The court system has been restructured, and a new Council of Judges—a self-governing body to make all decisions regarding recruitment, promotion, and punishment of judges—was established in March 2018. However, one of its first actions was to issue a report criticizing the courts’ lack of independence. Judges are still subjected to heavy political pressure, especially in national security cases.

Many of the abuses of the justice system originate in the General Prosecutor’s Office (GPO). Despite losing some of the punitive and oversight functions it had retained from the Soviet era, the GPO remains a powerful instrument in the hands of the presidential administration. Under General Prosecutor Yuri Lutsenko, just as under his predecessor Viktor Shokin, the GPO has failed to prosecute the country’s previous leaders for embezzlement even though some of the stolen money was returned to state coffers. Instead, critics charge, the GPO’s priorities are to demonstrate its loyalty to the president and to de facto preserve its previously extensive powers.

Anticorruption and judicial reforms intersect when it comes to the crucial issue of setting up a specialized anticorruption court, a move recommended by the IMF in particular to break the deadlock in prosecuting corruption cases but resisted thus far by the president. The Ukrainian elites’ willingness to cede power to a special court will be the crucial indicator of their commitment to fighting corruption and achieving real progress in this area.

Obstacles to Reform

Over the past four years, the main drivers of the reform have been Ukraine’s Western partners and its active nongovernmental sector, putting pressure on the government in what has been called a “sandwich” maneuver. Most of the political class has taken a mainly transactional approach, welcoming some initiatives and resisting others while the wider public has been disengaged.

Ukraine’s two main international donors, the European Union and the International Monetary Fund, can take credit for having ensured a much-needed macroeconomic stabilization after the collapse of the economy in 2014. They have used their financial leverage to promote reforms. The IMF has provided $8.6 billion of the $17.5 billion promised in loans since 2015—although the program is presently on hold due to the government’s failure to establish the anticorruption court and implement another gas price hike. Of the EU’s promised macrofinancial assistance of 3.4 billion euros, 600 million euros have still not been delivered to Ukraine due to unfulfilled commitments, mainly in the field of anticorruption.

Fierce resistance to reforms comes from the veterans of the old oligarchic system, which managed to survive as the country was distracted by the traumas of the Euromaidan revolution and Russian military intervention. Four years after the uprising, competition among so-called financial-political groups remains a central feature of Ukrainian political and economic life. These groups are much better organized and resourced than civil society actors. Although Russian gas, formerly the leading source of corruption and rents, has been eliminated, these powerful economic actors now focus their efforts on getting control of other parts of the energy and agriculture sectors and the vastly increased military budget. Many of them still wield influence in Ukraine’s divided parliament, where the government has to rely on a fragile coalition to govern and which has been slow to implement a program of reform legislation.

The Ukrainian public has not been enthused by much of the new reform agenda and remains alienated from the entire political class. All opinion polls consistently reveal the public’s low confidence in the ruling elite, including the Poroshenko administration, opposition parties, and their leaders. The church, the army, and civic volunteer groups enjoy much greater public confidence. Opinion polls show that social issues—in particular price increases—top the list of public concerns. With the 2019 elections looming, the issue of the social impact of the reforms is rising up the political agenda and is the major reason why Yulia Tymoshenko is ahead in opinion polls.

Still Waiting to Turn the Economic Corner

The success or failure of Ukraine’s reforms will mainly be determined by whether or not they deliver economic benefits to the public. Currently, the country’s economic performance is disappointing. The economy grew by 2.5 percent in 2017 and could have been higher barring the government-supported trade blockade imposed in March 2017 on the Russian-backed eastern regions of the country, which resulted in a 4 percent decline in Ukraine’s 2017 industrial production.

The ongoing trade war with Russia has also had a major negative impact. Ukrainian exports to the EU have reached pre-crisis levels and now account for 35 percent of Ukraine’s total exports, but they cannot offset the loss of trade with Russia. The Ukrainian hryvnia, at 26 to the dollar, is now worth only one-third of what it was before the Euromaidan revolution. Inflation, the biggest concern of ordinary citizens and a major reason why the opposition attracts support, remains stubbornly high at almost 14 percent.

The biggest constraint on growth is low investment. Gross capital investment amounts to 15 percent of GDP, well short of the 25 percent necessary (but not forecasted) for Ukraine to reach annual growth rates of 6 or 7 percent. Foreign direct investment, worth $2.3 billion in 2017 (after $3.3 billion in 2016 and $3 billion in 2015), was too small to produce an economic surge. Domestic investment of $16 billion was the main driver of growth. Investors’ confidence has grown slightly according to a survey by the European Business Association, but corruption, weak rule of law, and the war in the east remain formidable deterrents.

Ukraine’s finances look precarious, considering that it will have to pay back loans amounting to some $12 billion over the next three years. Moreover, even though the Stockholm Arbitration Court ruled in favor of Naftogaz in the dispute with Russia’s Gazprom, the government faces other claims. A London court is considering Russia’s claim of $3 billion, which it had loaned to the government of former president Viktor Yanukovych. Prominent oligarch, Ihor Kolomoyskyi, a former co-owner of Privatbank, is also suing the government for damages amounting to $4.7 billion.

In these challenging economic circumstances, it is no surprise that Poroshenko has declared overcoming poverty and increasing living standards as his administration’s key goals for 2018. Government policies—such as raising the minimum wage—as well as the growing economy and demand for labor have led to wage increases of 18.9 percent year-over-year in real terms. Average wages reached 8,777 Ukrainian hryvnia (about $334), compared to 3,619 hryvnia in 2013. Yet, in the current low-growth environment, these measures risk pushing the currency lower and inflation higher.

To Elections and Beyond

Poroshenko and his team are determined to secure his reelection in 2019. However, success is not guaranteed, even if the state apparatus relies on the tried-and-true methods of gaining support through murky media and “administrative resource”—the process whereby local officials guarantee the votes of government workers and rural voters. Ukraine’s capacity for democratic pluralism remains strong and the appeal of a populist challenger such as Yulia Tymoshenko will remain high. Ukraine’s Western partners will need to be vigilant to all this, engage with the entire political spectrum and not merely insist on changes to the electoral law, but free and fair elections.

In the contest between Ukraine’s nation- and state-building agendas, the latter is likely to suffer as elections approach. Poroshenko and other politicians will play the patriotic card in a bid for the estimated 40 percent of voters who regard themselves as “Ukrainian patriots.”

Against this background, reforms will continue at a slower pace. Judicial and public administration reforms, for example, are likely to suffer as the president increasingly favors loyalty in his subordinates above competence. Ukraine’s Western partners will continue to push for more reforms in the energy sector, where the government is feeling pressure due to Russia’s plans for a Nord Stream II pipeline, designed to provide an alternative route for its gas exports to Europe that will reduce Ukraine’s leverage vis-à-vis Russia. Efforts to improve energy efficiency throughout the Ukrainian economy are already under way.

Land reform is an extremely sensitive political issue, but if handled well the government can deliver impressive results. After twenty years of putting it on hold, the government could start, with the support of Western institutions, by investing in a proper land registry to clear the way for legal and transparent land sales.

Last but not least, Ukraine’s decentralization reform, which has enhanced local budgets and brought the most benefits to local regions in the form of improved and less corrupt administrative and infrastructure services, will continue.

The biggest unanswered question of the next few years is whether there can be substantial economic improvement. Ukraine’s Western partners and the general public can agree on the urgent need to increase long-term investment. The EU has devised a $1-billion-euro investment plan for Ukraine. Welcome as it is, it looks less ambitious than Lithuania’s idea of a $5-billion Marshall Plan for Ukraine, and much of it is set to come from unused funds at the European Bank for Reconstruction and Development and the European Investment Bank rather than any new funds.

In the medium term, the financial situation will remain fragile, given monetary reserves of $18.5 billion and outstanding Western loans of around $12.5 billion. In practical terms, that means the government must steer a path between the demands of Western financial institutions—the IMF in particular—and a mass of voters who want to see improvements in their socioeconomic situation.

The IMF and the EU have a lot of leverage. But Western institutions must tread carefully so as not to be seen as interfering directly in Ukrainian domestic affairs. They need to tailor their policies to the concerns of the wider public. A former Ukrainian negotiator who worked on the Association Agreement with the EU summed up the mood in Kyiv, saying that the EU is overemphasizing the “liberal economic agenda – free trade, removal of barriers, regulatory approximation”—while not paying enough attention to inequality and poverty. Ukrainians are aware that Europe has both a liberal order and a strong social welfare system and believe that the latter is being neglected in their case. In other words, the West will be seen as a political factor in the upcoming election. Unfairly or not, the public perceives it as being responsible for measures such as the doubling of the gas price, which is now worth one-third of an average Ukrainian monthly salary.

Ukraine’s Western friends have to be skillful jugglers in the run up to 2019. They need to promote continued reform and do what they can to hear the public’s concerns about low living standards, all the while engaging with the whole field of political actors as they get ready to fight the elections.

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